A U.S. Default Seen as Catastrophe Dwarfing Lehman’s Fall

A closed sign hangs at the entrance to the U.S. Treasury building in Washington D.C. on Oct. 3, 2013. Treasury Secretary Jacob J. Lew has said the government will have only $30 billion of cash left by Oct. 17 to meet its commitments. Photographer: Julia Schmalz/Bloomberg

Oct. 7 (Bloomberg) -- Anyone who remembers the collapse of
Lehman Brothers Holdings Inc. little more than five years ago
knows what a global financial disaster is. A U.S. government
default, just weeks away if Congress fails to raise the debt
ceiling as it now threatens to do, will be an economic calamity
like none the world has ever seen.

Failure by the world’s largest borrower to pay its debt --
unprecedented in modern history -- will devastate stock markets
from Brazil to Zurich, halt a $5 trillion lending mechanism for
investors who rely on Treasuries, blow up borrowing costs for
billions of people and companies, ravage the dollar and throw
the U.S. and world economies into a recession that probably
would become a depression. Among the dozens of money managers,
economists, bankers, traders and former government officials
interviewed for this story, few view a U.S. default as anything
but a financial apocalypse.

The $12 trillion of outstanding government debt is 23 times
the $517 billion Lehman owed when it filed for bankruptcy on
Sept. 15, 2008. As politicians butt heads over raising the debt
ceiling, executives from Berkshire Hathaway Inc.’s Warren
Buffett to Goldman Sachs Group Inc.’s Lloyd C. Blankfein have
warned that going over the edge would be catastrophic.

Lehman Aftermath

“If it were to occur -- and it’s a big if -- one would
expect a series of legal triggers, potentially transmitting the
default to many other markets,” said Mohamed El-Erian, chief
executive officer of Pacific Investment Management Co., the
world’s largest fixed-income manager. “All this would add to
the headwinds facing economic growth. It would also undermine
the role of the U.S. in the world economy.”

The U.S. stock market lost almost half its value in the
five months following Lehman’s failure. The country had its
worst recession since the Great Depression, taking the global
economy down with it. Unemployment surged to 10 percent, the
highest in three decades.

Another depression was prevented only by unprecedented
action by the Federal Reserve, which pumped $3 trillion into the
financial system. The U.S. Treasury provided about $300 billion
of capital for the nation’s banks.

“If we miss an interest payment, that would blow Lehman
out of the water,” said Tim Bitsberger, a former Treasury
official under President George W. Bush and now a New York-based
managing director at BNP Paribas SA. “Lehman was an isolated
company, and now we are talking about the U.S. government.”

‘Nuclear Bombs’

Buffett has asked politicians to stop using the debt limit
as a weapon in policy debates. Morgan Stanley CEO James Gorman
urged employees to contact their congressmen to remind them
about the “unacceptable consequences” of a default.

“It should be like nuclear bombs, basically too horrible
to use,” Buffett, 83, said in an interview published by Fortune
magazine last week.

The yield on 10-year U.S. bonds dropped to a two-month low
of 2.58 percent on Oct. 3. It was 2.61 percent at 10:25 a.m. in
New York trading today. While short-term bill rates and the cost
to insure against a default have risen, volatility in Treasuries
has fallen, a sign that investor confidence in the Fed’s bond-purchase program is outweighing worries over the budget battle.

Bond prices didn’t foretell Lehman’s default either. Ten
days before the bankruptcy, Lehman bonds were trading at about
95 cents on the dollar, the same level as JPMorgan Chase & Co.
debt at the time.

‘Holy Cripes’

One unexpected consequence of Lehman’s collapse was the
seizing up of the repurchase agreement, or repo, market -- a
form of secured, short-term borrowing used by Wall Street banks
and investment firms. Many of Lehman’s trading counterparts
discovered the collateral they believed was backing their loans
wasn’t there to grab as rules allowed. That scared investors in
the rest of the market, closing off other trades and leading to
fire sales of securities and further price declines.

A government default could freeze the repo market more than
Lehman’s collapse because U.S. debt forms its backbone. At least
$2.8 trillion of Treasuries serve as collateral for repo and
reverse-repo loans, according to Fed data.

In the event of a default, Treasuries might no longer be
eligible as collateral for repo agreements, according to James
Kochan, Wells Fargo Funds Management LLC’s chief fixed-income
strategist. The cheap funding for the holdings lowers the yields
demanded on the investments, and unwinding the positions could
amplify losses for lenders and borrowers.

If Treasuries were ejected from the market, “Well, holy
cripes,” Kochan said in an interview.

Congressional Gridlock

In 2011, the last time Congress was gridlocked over the
extension of the debt ceiling, repo rates rose as money-market
funds pulled back because they didn’t want the risk of holding a
security in default.

“A lot of this is about fear of the unknown,” said Scott
Skyrm, a former head of repo and money markets for Newedge USA
LLC and author of “The Money Noose: Jon Corzine and the
Collapse of MF Global.” “There is no upside to being in the
market in that environment, so people pull out.”

The U.S. didn’t default on its debt in 2011. Republicans
and Democrats reached a last-minute deal to raise the borrowing
limit. Even so, the posturing hurt consumer confidence and wiped
out $6 trillion of value from global stocks.

Historical Lessons

While none of the people interviewed for this story expect
the world’s largest economy to default this time either, most
say the chances of it happening now are higher than in the past.

“It would be insane to default, but it’s no longer a zero-percent probability,” said Simon Johnson, a former chief
economist of the International Monetary Fund who teaches
economics at the Massachusetts Institute of Technology and is a
columnist for Bloomberg View.

The U.S. hasn’t defaulted since 1790, when the newly formed
nation deferred until 1801 interest obligations on debt it
assumed from the states, according to “This Time Is
Different,” a history of financial crises by Carmen Reinhart
and Kenneth Rogoff.

In 1933, the U.S. refused to make payments in gold to
redeem bonds that gave holders the option of requesting the
precious metal instead of cash. While investors were paid on
time and in full, some argued it was a default because they
couldn’t claim payment in gold. The Supreme Court ruled that the
government was within its rights to deny such claims as long as
it paid the dollar amounts.

Technical Default

In 1979, the U.S. was late to make payments on about $122
million of bills, in part because of “severe technical
difficulties” that the Treasury said stemmed from a word-processing failure, according to the Financial Review’s August
1989 issue. While payments were made after a short delay,
including with interest for tardiness, the hiccup caused yields
to rise by half a percentage point and stay there for months.

A default today could be deemed “technical” because it
would be the result of the government’s unwillingness to pay,
not its ability, JPMorgan analysts including Alex Roever said in
a report last week.

In a technical default, only the prices of Treasury bonds
that mature or have coupon payments would fall, according to the
analysts. Money-market funds wouldn’t be forced to sell
government bonds, and the Fed probably would continue accepting
them as collateral for emergency cash.

That distinction is nothing more than an effort to downplay
the danger of default, according to MIT’s Johnson. Sovereign
defaults are always about the political will to pay because most
governments can print money to make payments if they want to,
Johnson said.

Insufficient Funds

Labeled technical or not, a default is still a default,
said Jim Grant, founder of Grant’s Interest Rate Observer.

“People have typically turned to Treasuries as a safe
haven, but what will happen when they realize it’s not safe
anymore,” said Grant, who has followed interest rates since the
1970s. “Financial markets are all confidence-based. If that
confidence is shaken, you have disaster.”

Treasury Secretary Jacob J. Lew has said the government
will have only $30 billion of cash left by Oct. 17 to meet its
commitments. Those can run as high as $60 billion a day, which
means the Treasury will need to borrow more to meet its
liabilities, Lew said. Goldman Sachs expects the Treasury’s cash
balance to be depleted by Oct. 31 and “possibly quite a bit
sooner,” analysts at the bank wrote in an Oct. 5 report.

Borrowing Costs

The Treasury has $120 billion of short-term bonds coming
due on Oct. 17, according to data compiled by Bloomberg. An
additional $93 billion of bills are due on Oct. 24. On the last
day of the month, $150 billion needs to be paid back, including
two-year and five-year notes that mature. The total due from
Oct. 17 through Nov. 7 is $417 billion.

While some expect a 2013 default will drive up yields only
on Treasury securities coming due, others including former
Deputy Treasury Secretary Roger Altman see a wider impact in
bond yields, pushing up borrowing costs.

“That would be higher interest costs over some
considerable period of time for the U.S. and for U.S.
taxpayers,” said Altman, who’s chairman of New York-based
investment bank Evercore Partners Inc.

Some point to Standard & Poor’s 2011 downgrade of the U.S.
credit rating, which led to an increase in Treasury prices, not
a drop. Even after the rating was lowered by one level to AA+
from AAA, investors continued buying U.S. government bonds as
they flocked to safety, according to Joe Davis, chief economist
at Vanguard Group Inc.

Disappearing Liquidity

A downgrade to default rating would be different, said
Peter Tchir, founder of New York-based TF Market Advisors.
Investors, structured vehicles, collateral agreements,
derivatives contracts and other trading covenants have ratings-based rules that could force the replacement of Treasuries in a
trade or portfolio, he said.

“Once the system starts to break down related to
settlement and payments, then liquidity disappears, as we saw
after Lehman,” Tchir said. “Perhaps the things we’re worried
about now will be fine after a U.S. default, but who knows what
others will not be.”

Treasuries are among the most popular forms of collateral
pledged at derivatives clearinghouses, including the one owned
by CME Group Inc., the world’s largest futures market.
Government agencies such as Freddie Mac and Fannie Mae, which
use interest-rate swaps and derivatives to hedge mortgage
portfolios, would be affected by a downgrade because it could
lower their counterparty ratings and result in more collateral
being demanded by trading partners.

‘Create Chaos’

“We can’t even imagine all the things that might happen,
just like Henry Paulson couldn’t imagine all the bad things that
might happen if he let Lehman go down,” said Bill Isaac,
chairman of Cincinnati-based Fifth Third Bancorp and a former
chairman of the Federal Deposit Insurance Corp., referring to
the former U.S. Treasury secretary. “It would create chaos in
financial markets.”

Higher borrowing costs could slow the housing recovery. If
30-year mortgage rates climbed to 6.5 percent from 4.5 percent,
a borrower who can now afford the monthly payment on a $200,000
loan would only be able to take on about $160,000 of debt when
buying a property, forcing down sale prices.

It would be “bad -- both for affordability and for
consumer confidence,” said Jed Kolko, chief economist for
Trulia Inc., an online property-listing service.

Banks would have to write down securities on their books
that are losing value and face capital shortfalls, according to
MIT’s Johnson.

“The government wouldn’t have the cash to rescue the banks
this time either,” Johnson said.

China, Japan

About half of the U.S. debt is held by foreign governments,
central banks and other overseas investors, according to
Treasury data. A default would throw those holdings into
question as well as the dollar’s status as the world’s reserve
currency, Johnson said. During the 2011 debt-ceiling scare,
foreign investors shunned Treasury auctions for about three
months, according to data compiled by JPMorgan.

China is the largest holder of U.S. Treasuries, with $1.3
trillion in July, according to Treasury data. Japan follows with
$1.1 trillion.

Even if Treasury prices aren’t affected by a default, the
damage in other markets could be devastating. U.S. stocks fell 7
percent in one day when Congress rejected the government’s bank-rescue package in 2008, before passing it a few days later.

Market Shocks

The market shocks would be enough to tip the U.S. back into
recession and drag the world economy down, according to Desmond
Lachman, a fellow at the Washington-based American Enterprise
Institute. The event could prove to be the trigger that reverses
a weak and fragile recovery, said William Cunningham, head of
credit portfolios for the investment arm of Columbus, Ohio-based
Nationwide Mutual Insurance Co. Lehman’s collapse was a similar
spark, he said.

“Is this the straw among other things that tips an economy
without drivers of growth back down into a negative spiral?”
Cunningham said.

While a short-lived default might be fixed without major
damage to the global economy, drawing a line between short and
long isn’t easy, according to Evercore’s Altman.

“If you missed an interest payment by two hours, the
markets might look entirely beyond that and forgive you,”
Altman said. “If you miss an interest payment by two days, four
days, six days, that’s a different story. It’s very difficult to
be scientific about this.”

‘Flying Blind’

During the final days of Lehman Brothers, Wall Street firms
set up war rooms to chart the potential impact of the firm’s
demise and prepare strategies to cope with the consequences.
Their scenarios, which focused on credit-default swaps, didn’t
forecast the contagion that quickly spread after the bankruptcy.

Now, some banks are preparing contingency plans for a
possible U.S. default, such as stocking retail branches with
more cash, the New York Times reported last week. Those
preparations might prove useless once again.

“Nobody knows what would happen if there were a default
because the reality is there’s never been even a technical
default in the U.S.,” said Russ Koesterich, chief investment
strategist at BlackRock Inc., the world’s largest asset manager.
“Everyone’s flying blind.”